A Nuclear Brexit?

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Summary

  • With the March trigger of Article 50 approaching, the May government's approach to Brexit over the past six months since the referendum shows surprisingly few changes in tone or content.
  • The May government lost an important decision in the High Court that will likely pave the way for a vote in Parliament on Article 50.
  • Fearing a Parliamentary vote on Article 50, the government could call for national elections in February. Rising inflation, flat wage growth, reduced purchasing power could spin a different electoral result.
  • After six months of preparation, the May government still lacks leverage. The one issue unifying the EU27 centers on the UK paying dearly in the Brexit process.

While the term "Brexit" has now made its debut in on-line Anglo-Saxon dictionaries the world over, the defining nuance of "soft" and "hard" Brexit lurks much deeper in the text. There is as yet no reference for "nuclear" Brexit, likely for good reason. While the popular spin on soft and hard Brexit continues to capture strong, populist passions fueled by immigration, border control and lost sovereignty - real or imagined - at the end of the day there was always a meeting of minds that Britain and the EU would find enough common ground to forge a post-Brexit relationship. Nuclear Brexit purportedly throws this assumption under the bus.

After six months to the day since the referendum, almost three months since her Birmingham address, after setting up two new Brexit departments, a number of Brexit cabinet subcommittees, 130 meetings with UK companies, hosting of 10 industrial roundtables and partnering with 12 more, a secret deal with Nissan for the Sunderland plant - there is amazingly little change in the May government's overall position on Brexit. It was only on Monday (19 December) that the government officially announced its support for a transitional deal to help smooth Britain's exit from the EU after 2019 - no doubt a begrudging climb-down from its wildly optimistic belief in completing a non-parallel first-time, highly complex divorce and then a full-fledged future trade arrangement with the EU in the space of the 2-year timeframe (logistically 18-months or by October 2018) allotted by the Article 50 process. The announcement was a welcomed development in UK business circles. Still, the pound and UK assets in general continued to feel the strong selling pressures:

  • The pound stood at $1.4874 on the eve of the Brexit vote. It has fallen to $1.2270 through Friday's (23 December) market close for a decline of 17.51% - a severe reduction in the purchasing power of the average household which is only compounded by an equally strong uptick in price inflation across the economy. Rising prices are particularly hard on the poor and working poor as basic necessities, such as food and energy, are priced in sterling at the local level. Welfare benefits were frozen last year through 2020;
  • While creating a potential currency-driven export boon, UK exports comprise less than 15% of overall GDP. Still 44% of those UK exports go to the EU;
  • The yield on the 10-year gilt was 1.375% on the eve of the referendum and has fallen to a yield of 1.201% through Friday's market close (23 December) for a decline of 12.65%;
  • The UK's current account deficit is expected to grow, which will place further downward pressure on the yield of the gilt due to increased government borrowing while the pound will likely continue to weaken against both the dollar and the euro as it approaches parity with the latter. The deficit is now at about 5% of total GDP;
  • Real household income dropped sharply in the 3rd quarter, growing at a 0.3% annualized pace for the weakest post in nearly two years as high inflation weighed in heavily on household purchasing power;
  • The pound may gradually lose its reserve currency status, shrinking from about 5% to about 4% of global holdings, according to S&P data.

Still, UK GDP growth managed to surge at an annualized rate of 0.6% during the 3rd quarter as British households appeared to be concentrating their spending in 2016 ahead of expected price increases in the New Year. The impact of the pound's decline has yet to fully migrate through the greater economy. Much of the growth came from the service sector, which grew at an annualized rate of 0.8% for the period. The other three sectors - industrial production, construction and agriculture - all contracted. The soft Brexit carrot of "…getting the best deal for those who want to trade in goods and services with the European single market…" curiously continues to comingle in the same sentence with the hard Brexit stick of "… guaranteeing that we will make our own decisions over how we control immigration, over our laws, ending the jurisdiction of the ECJ, and over the way we spend taxpayers' money." Curiously, the May government sees no conflict with the two goals. The government's obsession with immigration has prompted a targeted cut of more than two-thirds from present levels of about 320,000 to less than 100,000 annually. The free movement of people is not just a tenet of the EU, but a founding principal of most free trade agreements the world over. The policy option is all the more curious given Britain's growing current account deficit that depends on foreign investors buying UK debt - a debt that is now close to 5% of total annual GDP.

The so-called nuclear Brexit option adds an array of new variables to the mix: political, logistic and legal:

Politically, the vastly divergent views of the two protagonists across the Channel appear headed for an ill-tuned, cacophonous crescendo rather than into an embrace of the soothing melodies of a Gregorian chant. The May government soldiers on to capture the pulse of her newfound political base of working-class Brexiters, many of whom are likely baffled by unending attention the exercise continues to command. Michael Barnier, the lead EU negotiator, has made no secret that his top priority is to apply a methodical, legalistic approach to decoupling a relationship that has spanned the past 40 years. The effort will then serve as a baseline to any future talks on the future EU-UK relationship - trade or otherwise. One of the thorniest of component pieces will no doubt be the EU legacy claims on the UK for everything from pension obligations for retired British diplomats to loan guarantees for Greece to outstanding and ongoing EU budgetary commitments to compensation for EU assets physically located in the UK. News reports put this figure at anywhere from €50 billion to €60 billion. The presentation of a formal EU bill of such magnitude would leave anyone gasping for breath, which is precisely the EU intent. Making Britain pay its EU liabilities is likely the single most unifying issue in the EU27. That the financial claim is but one of a plethora of component pieces that comprises the EU-UK divorce package is a numbing realization indeed. Numbing or not, the completed picture is a prerequisite in the EU view toward moving to the next stage, that of negotiating the future of the EU-UK relationship.

The best-case scenario here would be a quick and clever tack by the UK at reducing the liability and then stretching the resulting sum over scores of years while deftly steering the conversation toward completing the divorce process as quickly as humanly possible. At worst the UK simply walks, exercising its nuclear Brexit card, throwing down the gauntlet for the International Court of Justice in The Hague to resolve. The showdown could take the better part of a decade to sort out, while the soft and hard Brexit scenarios of old would become melancholy reminiscences over afternoon tea in comparison. Is Britain's nuclear card play credible?

The real scenario of course lurks somewhere between these two extremes, but toward which side the eventual solution tilts at the moment is anyone's guess. Brexit hardliners will make it extremely difficult for the government to bend to Brussels' financial demands irrespective of legal basis, while the EU for its part will be very difficult to roll over from claims it feels are justified. The EU will be extremely careful not to create a precedent for action by another member-state as a result of its negotiations with the UK, either in the divorce or future relations phase, that could in any way undermine the European project. There is little doubt, however, that the divorce proceedings will color the rest of the negotiation process.

The parliamentary variant pushes the political dimension in several different directions. The May government's decision to keep a tight lid on the Brexit debate by insisting on its sole right to trigger the Article 50 process without a parliamentary debate was dealt a lethal blow in a unanimous decision by the High Court. Under the ruling, the court struck down the government's claim of royal prerogative, an obscure precedent drawn from centuries of court rulings and opinions dating back to the Magna Carta (1215). With the ascension of William of Orange to the throne in the Revolution of 1688, parliament passed legislation that curtailed the use of royal prerogative either to make or dispense with laws. That appears to have been one of the main legal premises used in the Court's decision. Article 50 has to be authorized by parliament: In the court's view, invoking Article 50 essentially nullifies the European Communities Act of 1972, an action that Parliament passed originally and only Parliament can repeal. The government has appealed the High Court's decision to the Supreme Court with a ruling expected in January.

It is highly unlikely the Supreme Court will reverse the High Court decision. The one point of legal minutiae that could spin the government's way is the fact that both sides in the High Court case assumed that the triggering of Article 50 is revocable at any time during the course of the two-year window. The May government would be hard-pressed to use this line of argument in its appeal, as it strongly rejects the notion that the Brexit process is in fact revocable. Further, a reversal of the High Court decision would refer the case to the European Court of Justice - a highly embarrassing venue upon which to rest such an appeal by a government that is actively working to rid the country of ECJ jurisdiction in post-Brexit Britain.

The May government's clear rejection of the ECJ will most certainly color the future EU-UK relationship, leaving the UK with a loosely defined free trade agreement with drastically reduced goods-only access to the single market as the best possible outcome of the Brexit process. Services, particularly financial services, would certainly not be part of such an agreement. Some sort of dispute resolution mechanism would have to rise to the surface if the agreement goes beyond a plain vanilla tariff reduction regime. The complexity of free-trade agreements increases proportionately with the inclusion of product regulation, state subsidies, labor relations, environmental standards - regulatory mechanisms that will certainly be required by Brussels for products coming into the single market. A free-wheeling autarchic offshore export market for goods and services will not likely be a winning proposition for the UK. Increasingly, the UK card to be played is not nuclear at all but the willingness of the UK to pay for access to the single market after leaving the EU, according to Brexit Secretary David Davis in a recent briefing of MPs. Sterling soared against the dollar, the euro and the yen on the news.

If the High Court decision is allowed to stand, the trigger to Article 50 will be the purview of parliament where the government has a slim 14-seat majority in the House of Commons and no majority at all in the House of Lords. The Supreme Court appeal will also consider the impact of Brexit on Northern Ireland, Scotland and Wales. Scotland and Northern Ireland voted by large majorities to remain in the EU and would likely provide enough votes to kill any Article 50 legislation that hits the parliamentary floor. The government could countermand the decision by calling a general election - the hardline euro-skeptic wing of the conservative party would insist on the move. With Labor and other opposition parties in disarray, an earlier than expected electoral mandate looks like a good bet, at least at first glance. Of course with inflation rising, wage growth flat, purchasing power dropping and government benefits targeting the poor and working poor frozen through 2020, a vote of confidence on the government's Brexit strategy to date could easily spin in a very different direction.

Logistically, there should be no illusion regarding the time constraints of Article 50. The sheer complexity of both the divorce and the future EU-UK relationship ranks the dual exercises as two of the most challenging in recent diplomatic history. The uber-political environment in the EU of the recent past makes the ratification process almost Herculean. The oft-stated goal of the Prime Minister is to go into the British national elections currently scheduled for 2020 with a comprehensive EU-UK agreement in hand. There are few observers outside the May government who feel such a timetable is reasonable. The CETA free-trade agreement between Canada and the EU alone took seven arduous years to complete, without a divorce overlay in the equation. The completed package was for all intents and purposes declared dead on arrival at its parliamentary debut in the tiny state of Wallonia - one of 38 national and regional parliaments that must render a unanimous judgment on the document before full implementation. A recent opinion by the ECJ advocate general will likely codify the practice for all EU free-trade deals moving forward, including any EU-UK deal that emerges. Accordingly, it is almost near certain that the UK will remain in the EU well past the 2020 national elections if the Brexit process gets that far - despite the Prime Minister's assurances to the contrary.

And then there is the busy European political calendar that kicks off with the Dutch national elections in March where the anti-EU Party for Freedom is well ahead in the polls and is likely to capitalize from the environment created by the Trump phenomenon in the US as well as the unfolding Brexit process in Britain. Ditto with the French elections in April and May where the perennial anti-EU candidate Marine Le Pen of the National Front are expected to get into the final round of voting. The German national elections happen in September where anti-EU populist parties continue to run strong in recent polling and where immigration remains a hot-button issue. Sandwiched in between will be the European parliamentary elections, currently scheduled to run from the end of August through the end of October. Early Italian election could materialize quickly on the horizon if the country's electoral law is passed by both houses of parliament. The three opposition parties in Italy all share a common anti-EU plank. National elections in Britain also have an outside chance of happening in February if the court ordered triggering of Article 50, as expected, lands in the British Parliament.

Legally, the EU currently assumes the responsibility for the regulation of vast portions of the UK economy - from food to drink to drugs to chemicals to transport, air travel and cross border data collection, to mention but a few. On the research side, the EU was responsible for about 40% of all cancer research funding, just over 60% of all nanotechnology research funding and almost 70% of all evolutionary biology research funding, according to data from Digital Science. Britain lacks the regulatory and oversight capacity to reassume these responsibilities any time soon, particularly within the 18-month construct of the Article 50 process. Taking over the costs of these responsibilities under the Article 50 window will be equally challenging. With just about half of UK exports being sold in EU markets, compliance with EU safety, environmental and a myriad of other standards will mean a heavy EU regulatory presence in British law for the foreseeable future, making next year's hope of repealing the 1972 European Communities Act far from certain and perhaps untenable.

Repealing the Act will also undermine the argument of equivalency in the application of British and UK laws. On the service side, equivalence comes forth at first glance as a workable principle upon which to build a future EU-UK trade relationship, particularly in the financial sector. Currently, UK and EU rules are largely in sync due to the UK's current status as a member state of the EU. Over time, that synchronization can be expected to diverge considerably as Britain reasserts its sovereignty in the post-Brexit era. Financial services require high degrees of jurisdictional certainty to operate efficiently. It requires an established set of rules for the execution of trades, the selling of products and services, the rendering of advice as well as an established regulatory process to insure both a level playing field and a fair adjudication regime when rules break down or are circumvented or when institutions are resolved in bankruptcy. A working definition of jurisdictional equivalence is difficult to maintain without a common baseline.

On the whole, Britain exercising a nuclear option at any one of the many choke points in the Brexit process will be determined by the perceived level of leverage London is able to wield over the proceedings. UK leverage remains glaringly weak. A very hard Brexit is the sine qua non of the EU negotiating stance, which is why the divorce and the future EU-UK relationship are not going to be parallel exercises. The first program out of the gate is the divorce package - which will be an EU version of the monstrous Budget Control Act of 2011 here in the US. As if in deference to sequestration, the EU divorce package will be designed to be so politically and economically noxious that the whole notion of Brexit will be simply unworkable from just about every reasonable measure. Of course sequestration did indeed become the law of the land in 2012, albeit with certain alterations. That said, the point here is the UK needs an agreement in short order; the EU has the luxury of time. The longer the process drags on, the longer the UK is suspended in a legal never-never land that will, necessarily, discourage even the thought of long-term investment on the part of business.

No one denies that Brexit is a zero sum game - if financial institutions are forced to take pre-emptive measures and move all or part of their operations out of the UK, the play is so much the better for EU audiences. Each side will endure financial pain when and if Article 50 is invoked. Britain will likely take the shorter end of this stick. Business decision makers will not walk over a cliff edge waiting for the May government to formulate a winning Brexit strategy. They will require some assurance, a timeframe for the Brexit process to play out - a timeframe the May government clearly is struggling to provide. And for good reason: The UK simply lacks leverage. Faced with such a cliff edge, business decision makers will take preemptive measures. Some have already done so and others will clearly follow suit - all pages directly lifted from the Brussels' playbook. Business and, in short order, parliament have the nuclear cards - they always did - over the Brexit process.

Who will play their card first - any bets?

This article was written by

Douglas Adams profile picture
1.58K Followers
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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